Which of the major stock markets are ‘cheap’ in 2018?

Bull or bear? Current stock market values may offer an indication of future returnsCredit:
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18 January 2018 • 5:00pm

Duncan Lamont, Head of research and analytics, Schroders

Buying low and selling high has become more difficult after several strong years. Valuation measures are the key to making wise investment decisions

Duncan Lamont

Head of research and analytics, Schroders

The investor is advised to try to buy low and sell high – but how do you achieve that? Valuation measures are the key. Invest when markets are expensive and future returns are more likely to be poor over the medium to long term. Buy when markets are cheap and the odds are stacked more in your favour.

Valuations cannot predict stock market behaviour over short time frames when fear, greed and other noisy factors tend to dominate. In any case, most investors might find regular investing is a way of removing the temptation of trying to time markets. Nevertheless, we have set out the latest valuations in the table above to help inform your decisions.

Finding value in stock markets at present is difficult after several strong years. The table shows a number of valuation indicators compared with their median of the past 15 years, applied to five regions. A description of each valuation indicator is provided in the next column.

Boxes shaded red are more than 10pc more expensive compared with their 15-year average; those shaded green are more than 10pc cheaper. Paler shades are applied to those in between.

No market is unequivocally cheap. An argument could be made that Japan is attractively valued with an above-average dividend yield and a low price/ earnings ratio.

Emerging markets have had a very strong 2017, returning more than 30pc and outperforming developed markets. Prices have become more expensive and the return outlook more moderate.

The United Kingdom hints at cheapness but is very expensive on a trailing price/earnings basis and is heavily reliant on the oil price recovery holding out, due to oil companies making up such a large chunk of the market.

The Brexit process, of course, cannot be forgotten – although any weakness in sterling should benefit overseas earners and may provide a counterbalance to domestic weakness.

Europe is better placed than valuations would suggest. A cyclical recovery is under way and there is room for profit margins to expand and support earnings and stock-market returns.

The United States sticks out as being the most expensive market but that has been the case for a number of years. The Trump administration’s tax-reduction plans should provide a short-term boost to corporate profitability and help to underpin prospects.

Five ways to measure stock market value

CAPE

The cyclically adjusted price-to-earnings multiple, or CAPE, is a key indicator followed by market watchers. It attempts to overcome the sensitivity that the trailing P/E has to the last 12 months’ earnings by instead comparing the price with average earnings over the past 10 years, with those profits adjusted for inflation. This smooths out short-term fluctuations in earnings. When the ratio is high, subsequent long-term returns are typically poor.

Forward P/E

Another common valuation measure is the forward price-to-earnings multiple or forward P/E. You divide a stock market’s value or price by the aggregate earnings per share of all the companies over the next 12 months. A low number represents better value. An obvious drawback is that no one knows what companies will earn in future. Analysts try to estimate this but frequently get it wrong.

Trailing P/E

This is perhaps an even more common measure. It works similarly to forward P/E but takes the past 12 months’ earnings instead. In contrast to the forward P/E, this involves no forecasting.

Price-to-book (P/B)

The price-to-book multiple compares the price with the book value or net asset value of the stock market. A high value means a company is expensive relative to the value of assets expressed in its accounts. This could be because higher growth is expected in future.

Dividend yield (DY)

The dividend yield, the income paid to investors as a percentage of the price, has been a useful tool to predict future returns. A low yield has been associated with poorer future returns.

A word of caution

Investors should beware comparing a valuation metric for one region with another. Differences in accounting standards and the makeup of different markets mean that some always trade more expensively. An alternative is to assess if each market is more expensive or cheaper than it has been historically, as we have done above.

Finally, investors should be mindful that past performance and historic market patterns are not a reliable guide to the future. Your capital is at risk with any investment.

Important Information: This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Regions/sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change. This content is issued by Schroder Investment Management Limited, 31 Gresham Street, London, EC2V 7QA. Registered No. 1893220 England. Authorised and regulated by the Financial Conduct Authority. UK12530

Important information: this article is intended to be for information purposes only and it is not intended as promotional material in any respect. The article is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Schroders has expressed its own views and opinions in this document and these may change. The article is not intended to provide, and should not be relied on for accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Unit Trust Ltd (Schroders) does not warrant its completeness or accuracy. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. Schroders recommends you seek financial advice from an independent adviser before making an investment decision. Issued in May 2016 by Schroder Unit Trusts Limited, 31 Gresham Street, London EC2V 7QA. Registered No: 4191730, England. Authorised and regulated by the Financial Conduct Authority. UK10716